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Physicist James Weatherall wrote The Physics of Wall Street which does a clear job of expounding the major errors quantitatively-trained non-risk takers tend to make when thinking about finance.

To see how derivatives work in the real economy, consider a tolling swap. In the old days if you wanted to build or buy a power plant, you had to raise equity capital and borrow money to get the plant, then you had to make the interest payments on the debt from the profits made selling electricity after paying for fuel and other expenses. With a tolling swap, you enter into a long-term contract to sell electricity and buy fuel. Since the electricity is worth more than the fuel, you get cash up front which you use to build or buy the plant. The plant is pledged as initial margin. Your mark-to-market payments depend on the difference between the price of electricity and the price of fuel, and exactly offset your profits (assuming you run the plant as efficiently, and up to the capacity, you planned). If you run the plant well, you will earn a nice income over and above the mark-to-market payments. If you don't run the plant well, you won't cover the mark-to-market payments and will lose the plant to your swap counterparty. The counterparty will not be unhappy, because if you owe a lot of money on the tolling swap, it means the price of electricity is high relative to the cost of fuel, so the plant is worth a lot and can cover the value of the swap. If the plant is not worth much because electricity is cheap relative to the cost of fuel, there isn't much value to the tolling swap, it may even have negative value.

Of course, the paragraph above is oversimplified; we have not made a full transition to a derivatives-based economy. I use it only to illustrate the concept.

Now we can see why pricing models are so important: They determine the mark-to-market payments. Like the interest rate in a credit-money economy, if they are set wrong the economy can overheat or stall, or can send resources to unproductive uses. Since Weatherall thinks all of finance is guessing future market prices, he discusses pricing models in that vein. A good model predicts future prices correctly, and allows the user to buy derivatives selling for less than their future price and sell derivatives selling at more than their future price. That is not the point at all. A good model sets good mark to market payments, so a robust cycle of profitable economic exchange occurs, generating profit for everyone. A bad model leads to unproductive economic activity, and often to crashes.

Consider the analogy with bank lending. We can consider the lending decision to be a pricing model. Banks consider various inputs and come up with an output, either a rejection of the loan or an acceptance with certain terms and a specified interest rate. Designing a good lending model requires consideration of the economy it will help build. The people who invented banking were well-versed in the considerations necessary to do this, and generations of trial and error have improved the process.

Now suppose a newly-created bank hires Weatherall to build it a lending model. He's a smart guy, so I assume he'll do a good job. But I also assume from reading his book that he'll misunderstand the assignment. He will think the goal is to predict which loans will pay off and which will default. He will study historical data of loans made by other banks and perhaps run a statistical discriminant analysis-or maybe some more sophisticated fourth generation model known only to professional physicists-to improve on the childishly simple models those banks use.

The problem is he will be approving the loans similar to the ones that were successful in the past-he will be lending to me-too people entering already overcrowded areas. In the short run, this will increase his success, more money pouring into the area will inflate prices. But he's backing the wrong people in the wrong businesses. In the end it will lead to misdirected economic efforts and disaster for his bank.

I may do him an injustice. He may foresee the problem above and come up with a model that accounts for it. But as long as he thinks his job is prediction of the future rather than designing a system, he will fail, however many levels of self-reference he uses. This is precisely what happened to many physicists and other quantitative professionals who jumped into jobs with me-too institutions and were too arrogant to listen to people with more experience. And this is another reason why I find the claim that physicists invented the modern financial system so annoying.

Next week I turn to the misunderstandings revealed in Weatherall's search for the greatest investor in the world.

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